Commentary

Don’t be fooled by market euphoria

Commentary: Falling world inflation isn’t cause for celebration

By

MichaelCasey

Columnist

Apart from a few pariah economies — Sudan, Venezuela, or Argentina — you’ll be hard pressed to find a genuine, double-digit inflation problem anywhere in the world these days.

Even Hungary, which seems to live permanently on the verge of a currency crisis, registered a mere 1.7% annual gain in its April consumer price index. Similarly low numbers are everywhere — including in the U.S., Europe and all other developed nations.

A giant wave of disinflation is hitting the world. That might sound like a good thing, but signs suggest it’s a less-than-benign phenomenon. In this case, falling prices are driven more by recessionary forces than by any improvement in output. It’s a lack-of-demand problem, not a positive supply shock. The culprits: complacent policymakers.

Euro-zone recession hard to shake

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The recession in the euro zone stretched into the first quarter of this year, demonstrating that a recovery remains more elusive than many expected.

To be sure, there are a few positive factors at play. The fracking revolution in the U.S., for example, is driving down energy prices, which is lowering manufacturing costs and providing consumers with more discretionary income. But for the most part, sliding commodity prices, one of the big drivers of falling inflation gauges, stem from weak demand in China and Europe.

Even the upbeat signals in the U.S. — a modestly improving jobs market, rebounding home prices and a phenomenal stock market rally — are merely a distraction from the harsh fact that the world’s largest economy is still averaging just 2% growth. That’s not enough to offset China’s downturn from 10%-plus rates two years ago to a 7-to-7.5% trajectory or the euro zone’s return to outright recession. Those two regions account for 25% of the world economy.

Paul Sheard, chief global economist at Standard & Poor’s in New York, sees the data as an indictment against governments, which are acting under the mistaken belief that the financial crisis is now behind us. “Policymakers have taken their eyes off the ball, given the still-precarious situation of the developed world economies,” he said.

The crisis ended four and half years ago, but it left the world with an unprecedented glut of excess production and we are still working through that. One poignant symbol of it lies in the ruins of the collapsed Rana Plaza factory in Bangladesh: international markets remain so awash with cheap clothing that garment makers are scrimping on safety standards to prevent producers in other low-cost countries from taking their market share.

Not long ago, falling global prices were a good-news story. In the 1990s and early 2000s, globalization opened up places like Bangladesh while the information technology boom ushered in a “New Economy” era of low inflation and high-productivity and growth. But the pace of change has slowed. There has been no big trade development since China joined the World Trade Organization in 2001 and some economists say our best innovations are behind us. In fact, for the time being globalization could be having a negative impact as international financial linkages help to rapidly spread the impact of a downturn in Chinese demand.

The big risk is that disinflation evolves into deflation. The damage from a global, self-perpetuating cycle in which prices fall and encourage deferred demand would be enormous.

Japan is the poster child for this problem, of course. So it’s fitting that its policymakers are currently taking their most aggressive measures yet to address it. But whether or not the Bank of Japan’s massive money-printing effort succeeds in generating inflation, the fact that it is currently acting alone speaks to how governments are too happy to let central banks do the heavy lifting.

Japan desperately needs structural reforms to inspire lasting growth. Instead its parliament keeps updating failed spending programs that merely expand the country’s already gargantuan public debt load. In the U.S., what’s needed is a two-pronged approach that cuts back long-term debt but also provides targeted short-term fiscal spending. Instead, Washington’s “fiscal cliff” compromise imposed immediate across-the-board cuts but did nothing to slow future Medicare and Social Security claims growth. In Europe, a failure to achieve more fundamental political and fiscal integration has been substituted with austerity measures that simply swell the ranks of the unemployed and starve output.

That’s left monetary policy holding the bag. Encouraged, or perhaps compelled by falling inflation, central banks around the world are now cutting rates or buying bonds en masse, much to the joy of stock and bond investors.

But don’t be fooled by market euphoria. The global economy won’t return to health until politicians take serious steps beyond monetary policy. And until they do, a major market correction is a real possibility.

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